Changing times

As the large buyout end of the market sits on its hands and desperately scours the globe for banks willing to lend, mid-market players continue to put cash to work, albeit in a changed deal environment. With many banks suffering under the weight of their off-balance sheet instruments and debt multiples down from the highs of last year, arranging the financing to support a deal is no longer as straightforward. 'We are hungry to invest and the banking community is active but with a slightly different debt solution. Clubbed debt is now the norm and underwriting tends to be more expensive as the underwriting bank needs to minimise risk and build that into the terms,' says Paul Marson-Smith, managing partner at Gresham Private Equity. 'The core banks are active and open for business although they are being choosier about the deals they back. There has also been a shift back to relationships and firms they are comfortable with,' says Richard Green, managing partner at August Equity. Neil Macdougall, managing partner at Silverfleet Capital (previously PPM Capital) confirms that 'the mid-market is open for businesses that the banks like in sectors they are comfortable with.' The mantra at present seems to be that 'any debt is good debt.' A consortium of lenders arranging a more expensive package on tighter terms may not be ideal but deals are getting done.

Banking shifts

For others, clubbed debt is a portent of the troubles to come. 'Ever-smaller deals being clubbed is a sign that the lack of liquidity is creeping into the mid-market,' says Paul Canning, managing director at H.I.G. European Capital Partners. 'Margins have gone up, flex clauses to protect lenders are sometimes required to get syndication away and underwriting banks are charging higher fees and passing them on to the syndicating banks to aid the syndication process,' says MacDougall. He also reveals that for a non-UK EUR200m deal the Silverfleet team looked at recently in the retail space 'we spoke to around 30 banks to see what appetite there was for underwriting the debt but couldn't bring enough of them together to do it.' Bill Crossan at Close Growth Capital says that this reluctance to lend 'is not logical. Banks that were 110% open last year are now 80% shut and the uncertainty is causing problems.'

Even once a private equity sponsor has agreed a debt package, the banking community is in such a state of flux that nothing is certain until the credit starts rolling. 'We saw a deal where we believed we had the funding arrangements in place only for the bank to change its mind a week later,' says Andrew B Harris, partner at DLA Piper. Lower down the market, activity could be mistaken for business as usual. 'We haven't seen a slow-down so far this year and have managed to secure financing on a single bank basis,' says Shaun Middleton, the managing director for new investment at Dunedin. Indeed, Dunedin recently completed two recapitalisations: CGI, a supplier and manufacturer of fire resistant glasses with £15m of new debt provided by Clydesdale Bank; and Capula, an IT automation solutions company with additional facilities of £6m provided by Barclays.

Propping up deal flow

On the face of it mid-market activity since the turn of the year is evidence of a resilient market, but the change in the capital gains tax regime helped prop up deal flow and must be factored into the picture. 'The capital gains tax changes expedited some deals and distorted the picture. Deals which may not have gotten away for another 18 months were pushed through,' says Will Rosen, partner at DLA Piper. 'The tax changes had a big impact on deal flow. In the first quarter of this year we did two quarters work,' confirms Bill Crossan at Close Growth Capital. First quarter deal volume for those deals in the £10m-£250m range exceeded Q1 2007 volume, although value was slightly down on the same time last year. (See graph below)

'A slowdown in deal-flow post capital gains is inevitable. On top of this many of the deals done in Q1 would have had debt in place six or seven months ago and in many respects it is even more difficult to arrange funding now than it was back then,' says one mid-market adviser. With a glut of deals spurred by the tax changes and problems in overgeared portfolio companies, some firms may now feel more comfortable sitting on their money until conditions improve. This could create a volatile market further down the line. 'Problems are potentially being stored up. If not many deals get done in the next six to nine months because people can't get the level of debt they require then you could have lots of desperate firms trying to invest in 12 months time,' says Middleton.

Distress signs

With the economy slowing and refinancings for the most part off the table, covenant breaches and defaults are a genuine concern for some firms who took an over-optimistic long-term view. 'We are beginning to pick up the signals of distress on highly levered deals. We are staying close to the institutions which may want to liquidate their positions as we can buy into the debt as well as the equity and are ready to move quickly. Spending too long getting the funding in place can see you lose opportunities,' says Canning. Others are less bearish but are keeping a close eye on their portfolios for the danger signals. 'None of our investments is facing difficulty at the macro level but we remain cautious about the wider economy and if anyone has a spare hour I tell them to spend it on portfolio health,' says Marson-Smith. A redeeming feature of the exuberance of the past few years was that the headroom provided on debt payment structures has served to insulate many portfolio companies from the short-term effects of a slowing economy. 'Few pre-crunch deals were structured with large amortising strips so defaults on debt repayments are unlikely,' says Nathalie Faure Beaulieu at European Capital. However she warns that, 'In general, sponsors will watch interest cover covenants more closely as they are more likely to tighten or break in case of underperformance.'

New opportunities

Amidst the doom-and-gloom few are forgetting that the best time to make money is during a downturn. 'The years following a period of correction have historically been a good time to invest. Wherever there are challenges there are opportunities,' says Green. 'There will be deals out there for assets which are fundamentally sound but currently may be part of a more distressed parent company,' believes Middleton. Looking at deals which may have an element of distress will present other challenges. 'Good commercial skills are essential because assessing a business plan in this environment is a lot more difficult,' Green says. Rosen believes that 'this is a great time for private equity houses pursuing a buy and build strategy,' but adds the caveat: 'You can't do a buy and build if you have to rebuild the platform.' With banks now requiring a compelling angle to fund a deal, bolt-on acquisitions are a good story and provide greater comfort for a lender.

'Deal flow is depressed at the moment but I have been through a few recessions and have never felt so positive about the future,' says Crossan, who points to Close Growth Capital's single source approach as the reason for such optimism (see box below). For mezzanine lenders in particular the current market presents an opportunity not seen in some time. 'We are closer to the transaction, from sponsors to the management and the yields are the healthiest we have seen in some time,' says Faure Beaulieu. However, there are those who believe that conditions in the market are exceptional and as such players which tout their abilities to turn distressed assets around may not hold the advantage some assume. 'I am not convinced that having a "distressed" focus is necessarily a winning angle. It is a long time since the market has looked like this so few have any experience of it. In addition, the expected volume of cheap deals may not materialise because so much money has been raised in recent years that it may underpin prices' says Sam Robinson, director at SVG Advisers.

Regardless of the volume of distressed assets in the marketplace over the next few months, reasons for optimism abound. Those banks which over-extended themselves are paying for their negligence and undergoing a necessary corrective period. This may be causing problems but the resourcefulness of the mid-market means that even in trying times its place as the driver of private equity activity in the UK remains undiminished.

THE DEBT + EQUITY APPROACH

Providing both the debt and equity on a deal and then possibly bringing in third-party debt at a later stage is a model historically utilised by only a few players but the certainty it provides in an uncertain market is tempting others to have a go. Sources say that ISIS Private Equity and Barclays Ventures are two mid-market players to have adopted this approach on recent deals. 'It is a big advantage if you can underwrite the deal. It gives management, the vendor and the corporate financier certainty, which is a big advantage in the current market,' says Garrett Curran at Close Growth Capital. To accusations that this model produces conflicts because the sole holder of the debt and equity will always look to protect the debt over the equity, Curran says 'we do the debt to protect the equity. If a deal structured in a traditional way starts to encounter problems and the lender looks at ways to get its money back it can act to the detriment of the business. We take less risk because we control all the money and we are not reliant on banks over terms and conditions of a loan.'

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